On December 20, 2021, Governor Gretchen Whitmer signed House Bill 5376 into law enacting a flow-through entity tax (“FTE Tax”) for those doing business in Michigan. Under this new law, an eligible flow-through entity can elect to file and pay taxes on the income that is attributable to owners at the entity-level instead of the owner’s individual tax return (of which a tax credit may now be claimed). This legislation was passed to help taxpayers get around the state and local tax (SALT) deduction limitation of $10,000.00 for federal income taxes that was imposed under the Tax Cuts and Jobs Act of 2017. This blog article will explain how the flow-through entity tax works and whether it is a good idea for your situation.
WHO IS ELIGIBLE AND HOW DO YOU ELECT TO FILE AND PAY THE FLOW-THROUGH ENTITY TAX?
A flow-through entity means an entity that is treated as a S-Corporation or partnership for federal tax purposes. MCL 206.805(3). A flow-through entity is NOT eligible to elect the tax if it is a publicly traded partnership, a disregarded entity, or a financial institution subject to the Corporate Income Tax (CIT). Id. A disregarded entity is an entity with a single owner that is not separate from the owner for federal income tax purposes (e.g. a sole proprietorship or a single-member LLC not taxed like a corporation).
For tax years beginning on and after January 1, 2021, a flow-through entity may elect to file a FTE Tax return and pay the taxes imposed. MCL 206.813. An election to file and pay the FTE Tax is “an irrevocable election that shall continue for the next 2 subsequent tax years and the taxpayer shall continue to file a return and pay the tax imposed” for the next 2 subsequent tax years. Id. A flow-through entity that elects to file and pay the FTE Tax must make the election by March 15 of that tax year (or April 15, 2022 for tax years beginning in 2021). Id. The election can ONLY be made by submitting an electronic payment to the state through Michigan Treasury Online (MTO). To be valid, the payment must be designated as applicable to the tax year for which the election becomes effective. Any payments submitted outside of MTO will NOT constitute a valid election to pay the flow-through entity tax.
A flow-through entity is subject to the tax if it makes an election to opt in and has “substantial nexus” in Michigan, meaning that the flow-through entity “has a physical presence in this state for a period of more than 1 day during the tax year, actively solicits sales in this state and has gross receipts sourced to this state, or is a member or has an ownership interest or a beneficial interest in a flow-through entity, directly, or indirectly through 1 or more other flow-through entities, that has substantial nexus in this state.” MCL 206.811(1). “Actively solicits” means EITHER “speech, conduct, or activity that is purposefully directed at or intended to reach persons within this state and that explicitly or implicitly invites an order for a purchase or sale” OR “[s]peech, conduct, or activity that is purposefully directed at or intended to reach persons within this state and that explicitly or implicitly invites an order for a purchase or sale.” MCL 206.811(2)(a). “Physical presence” means “any activity conducted by the taxpayer or on behalf of the taxpayer by the taxpayer’s employee, agent, or independent contractor acting in a representative capacity.” MCL 206.811(2)(c).
HOW MUCH IS THE FLOW-THROUGH ENTITY TAX?
Generally, the Michigan FTE Tax is levied at the same rate as the individual income tax, presently at 4.25%. However, the actual tax computed is subject to a number of adjustments:
- Additions and Subtractions: The flow-through entity has to make certain additions and subtractions to computing its business income tax base found in MCL 206.815. For example, additions to the tax base are made for income and dividends from government bonds and charitable contributions, but subtractions are made regarding guaranteed payments for services and tax refunds received.
- Tiered Structures: A tiered structure is a situation where a flow-through entity has at least one other flow-through entity that is not a member. Each flow-through entity within the tiered structure may elect (or not elect) to pay the FTE Tax. Special adjustments found in MCL 206.815 are implemented to ensure that all direct and indirect members receive the appropriate credit on their individual tax returns and that the FTE Tax is not paid more than once on income flowing through the tiers.
- Tax Base Adjustments: To avoid double taxation within a tiered structure, positive distributive shares from another entity that elects to pay the FTE Tax must be removed from the tax base of the filer under the adjustments in MCL 206.817.
- Prohibition for Flow-Through Entities Claiming Credit For Tax Paid By Another Flow-Through Entity: A flow-through entity is prohibited from claiming a credit for FTE Tax paid by another flow-through entity electing to pay FTE Tax. MCL 206.819. Instead, the credits are passed through via reporting between flow-through entities and members to be claimed on the member’s income tax returns.
WHEN MUST ESTIMATED TAX PAYMENTS BE MADE FOR THE FLOW-THROUGH ENTITY TAX?
A flow-through entity “that reasonably expects liability for the tax year to exceed $800.00 shall file an estimated return and pay an estimated tax for each quarter of the taxpayer’s tax year”. MCL 206.831(1). “The interest and penalty provided [for failing to make estimated payments]… shall not be assessed for the 2022 tax year and each subsequent tax year, if the preceding year’s [FTE] tax liability… was $20,000.00 or less and if the taxpayer submitted 4 equal installments the sum of which equals the immediately preceding tax year’s tax liability.” MCL 206.831(2). Estimated payments are a credit against the overall FTE Tax due during the tax year. MCL 206.831(4).
WHEN MUST THE FLOW-THROUGH ENTITY FILE THE ANNUAL RETURN?
A flow-through entity electing to pay the FTE Tax must file an annual return by the last day of the third month at the end of the taxpayer’s tax year (or March 31 if using the calendar year). MCL 206.833(1). The flow-through entity will be required to file Form 5772 (Flow-Through Entity [FTE] Tax Return) along with supporting schedules in Form 5773 (Schedule for Reporting Non-electing Flow-Through Entity Income) and Form 5774 (Schedule for Reporting Member Information for a Flow-Through Entity. The flow-through entity may request and receive a 6-month extension to file the annual return, provided that it was requested before the due date. MCL 206.833(3).
HOW DO FLOW-THROUGH ENTITY MEMBERS CLAIM THE BENEFIT OF THE FTE TAX?
“A taxpayer who is either a member of a flow-through entity that elects to file a return and pay the [FTE] tax imposed… or a direct or indirect member of another flow-through entity that elects to file a return and pay the [FTE] tax imposed… may claim a credit against the tax imposed under this part in an amount equal to the member’s allocated share of the tax as reported to the member by the flow-through entity [on a Schedule K-1 or other informational document] for the tax year ending on or within the taxpayer’s same tax year.” MCL 206.254(1).
If the flow-through entity member is a resident or non-resident estate or trust, then the amount of the tax credit due must be determined by using the calculations found in MCL 206.254(1) and MCL 206.254(2). Estates and trusts are required to report their share of the tax to their beneficiaries.
“If the credit allowed under this section exceeds the tax liability of the taxpayer for the tax year, that portion of the credit that exceeds the tax liability shall be refunded.” MCL 206.254(4).
Since the flow-through entity is paying the state income tax due at the entity-level instead of at the member-level, that member is reporting less SALT obligations on their individual tax returns. This means that the flow-through entity member realizes a greater benefit when itemizing for federal income tax purposes because it is more likely the remaining SALT obligations paid will be at or below the $10,000.00 threshold. It is up to the members in the flow-through entity to determine if electing to file and pay FTE Tax is the best decision for their individual situations.
OUR TAX PROFESSIONALS CAN HELP YOU DETERMINE IF ELECTING TO PAY PASS-THROUGH ENTITY TAX IS THE RIGHT MOVE FOR YOU
Taxpayers who have an ownership interest in a flow-through entity in Michigan that itemize on their federal income tax returns should take the time to explore if electing to pay FTE Tax will save them money in the long run. Our tax lawyers can evaluate your situation and help you make an informed decision.
If you have further questions or need help filing your taxes, then do not hesitate to contact the experienced attorneys at Kershaw, Vititoe & Jedinak PLC for assistance today.